Professor Rodrigo Canales discusses his research into the trade-offs inherent in social enterprises and argues that people interested in the field should pay closer attention to the challenges of achieving both social good and market success.
Social enterprises are hybrid creatures. They promise to bring some of the benefits of for-profit companies—efficiency, focus, access to capital—to bear on the social ills traditionally addressed by mission-driven NGOs and other nonprofit organizations.
Microfinance might be the best-known example. Here the hope is that institutions that make small loans to poor people can both improve the lives of their clients and generate a profit, and that profit can be used to lure investors or grow the firm’s lending activities. This promise has led to spectacular growth: the nearly $100 billion microfinance industry now serves more than 200 million people. The field is highly international, with cross-border investments of $25 billion in 2011.
Yale SOM professor Rodrigo Canales studies the role of institutions in social enterprise and other industries, and we asked him to talk about how his work draws out the tensions and trade-offs that exist in such two-headed enterprises. For example, a microfinance lender has an incentive to automate processes, in order to keep expenses low and profit margins high. However, the more a microlender automates its processes, the less it invests in meeting the distinctive needs of the poorest clients, who are likely to be unfamiliar with the financial system.
“The reason why we need social enterprise in general is because the market hasn’t fixed [the problem],” he says. “If it was economic, the market would have solved it a long time ago. So we need hybrid models or social enterprise models that can kind of bring the market into this problem in a way that bridges it. But let’s be clear that the market hasn’t fixed this and there’s no way the market can fix it in and of itself. So there’s a trade-off there.”
Q: Can you explain the tension between profitability and social impact in microfinance?
Rodrigo Canales: There’s two ways to understand the tension between profitability and social impact in microfinance. One of them is structural. The reason there is that microfinance, as the name says, is about providing very, very small loans to people, mostly destitute clients. It’s mostly impoverished or relatively destitute populations. Usually these populations are in rural or remote areas. So what you have is a lot of people who are scattered around who are going to be receiving very, very small loans. So just by the nature of that, it means that you need agents who are going to go out and look for these clients and sell them the idea of taking on a loan and explain to them what a loan means and then educate them in the process. And then, actually granting a loan and then supervising how the loan does. Again, because these people are in very remote areas, that means that you need people to go out and find them.
If you think about how finance works, you’re doing all that work and you’re only granting them very small loans. So the “bang for your buck” that you get for providing the service is relatively small. So that means that it’s an inherently expensive service to deliver. There’s two ways in which microfinance organizations can cover the costs of providing that. One is just by charging high interest rates. If you look at the average interest rates that are normally charged by microfinance companies, when you look at them, the first time you see them, they seem extremely high. Usually people that are not familiar with industry, the first time they see the interest rate, its like, “Wow. This is interest that you’re charging to poor people? How is that possible?” Well, the reason is that it’s an incredibly expensive service to provide.
Now the reason why it’s okay to charge such high interest rates is, number one, you have to recover your costs, but number two, usually people who receive microfinance loans can make very productive investments with them. So it’s unquestionably a good deal for the recipients of the loans, even if you’re charging them a relatively high interest rate.
The second way in which microfinance organizations can absorb the cost of such an expensive service is to try to standardize it or automate it in any way possible. So there’s– you try to find any kind of economy of scale that you possibly can. Basically, if you have loan officers who are going out there, what you want is that each loan officer should have as many loans under management as possible so that the most expensive thing is the salary of that loan officer. So you basically want to get as much as possible from that same individual. The way to do that is to try and automate or standardize as many of these processes as possible.
So right there, you have the tension between sort of the structure of the service that is very, very costly and all of the needs of the organization to try and basically get as much as you possibly can from that expensive service or the expense of providing the service.
Now the second layer of tension comes from the fact that if one of the economic ways for you to solve how expensive it is to provide the service is to automate or standardize the decisions, the problem with that is that you have clients who are very poor or at least relatively poor and who basically have very specialized needs. So because their needs are specialized, it’s actually extremely difficult to standardize the service. They need a lot of customization, right?
It’s very difficult to, for example, create an algorithm that automates whether you should grant a loan to these people or not because they all look very different and they don’t have a lot of, let’s say hard information or systematic information in a database out there somewhere that you can just log in and look at them and then decide whether these people are good clients or not. You actually have to go in and analyze one by one. If they get in trouble, for example, it’s kind of very difficult to know what, as an automated response, what you should do with that because each client has very, very specialized needs.
That’s where the tension between the need for profitability or cost reduction and the need for customization arises. If you truly want to have a social impact, that means you need to provide very customized services for these clients because that’s what they require. They require a lot of education. They require help on their specific business ideas. They require help on their specific problems or needs that arose that maybe led them to not be able to repay a loan on time, for example. So they have very specialized needs, yet, your organization has all this pressure to standardize and automate as many of the things as they possibly can just because of the nature of the service that they’re providing.
So that’s kind of a summary of the structural reason for these tensions between standardization and social impact.
Now there’s a second layer to this, which is that one of the reasons why microfinance became so popular as a tool to alleviate poverty in the ‘70s and ‘80s is because, as people started providing microfinance services in Bangladesh and in other Asian countries, it kind of became clear that poor people could pay a high interest rate. They could make really productive investments and say they could actually pay a high interest rate and that made it seem like there was kind of no tension there. Meaning, you can go out, give them a loan that is going to help them work themselves out of poverty because they can make investments that are very productive for them and they can pay the cost of it. So you don’t need donor money.
The promise was that you have this self-sustaining machine that could help poor people work themselves out of poverty. When that came out and evidence started coming out that these loans that had no collateral that were very small, that were very productive for destitute people, that allowed them to improve their economic lives could become sustainable for an organization or could be delivered without the need for donor funding, necessarily, it started drawing a lot of attention from external donors and people who were interested in industry or who were interested in poverty alleviation in general. So a lot of donor money started coming into microfinance and that started growing the industry.
As the industry grew, the first layer, let’s say the first wave of money was probably donor money who thought this was a good way to get additional impact for their money. But then, when other people started realizing that there was a return to be made in here, like in some cases, the interest rates that you can charge to the poor, especially if you have a good organizational structure that allows you to keep, for example, default rates low, you can actually make a decent return on your money. So what a nice equation that you can sort of invest in this thing that makes you feel good because you’re helping the poor and you end up getting a nice return.
So then, actual investors, regular investors started pouring money into microfinance and as they did that, they started bringing in the evaluation metrics and the evaluation models that they use for their traditional investments. When they did that, then they started putting additional pressure and bringing in all the models of formal finance into microfinance. So there was already a structural tension to try to automate and try to sort of standardize things as much as possible. When, external investors come in who have the mindset of traditional finance, they create even more pressure to do this. Now they start demanding it from the organizations. So what you see is, throughout, especially the ’90s, all these microfinance organizations begin to adopt the technologies and the models and the organizational structures of, let’s say, large scale banking. That includes credit score models and things like that. That’s sort of the second layer of the tension that was created.
If you notice, in all of this—these things that I’ve described, especially in the second wave of investors coming in and pushing for more efficiency, more profitability of microfinance, the assumption was there is no trade off. If we automate things, if we standardize, if we become more efficient organization, the only thing that’s happening is that you’re turning this organization into a more profitable organization. The rationale was well, that allows you to reach even more people. If you become more efficient, then that means that you can—for the money that you could previously use to reach 100 clients, now you can reach 200 or 300. Therefore, your impact multiplies. There’s no trade off there and that’s a bit of a devil’s deal because it turns out that there is a trade off there. The more you automate, the less you can customize and the less you can focus on the specialized needs of the poorest clients. So there is a trade off there that was not acknowledged until very recently.
Q: Do you see lessons for other forms of social enterprise?
Canales: Absolutely. One of the reasons why I’m so passionate about this work in general is, the term social enterprise and the social enterprise “movement” has kind of taken off recently. Our students here, for example, love the concept of social enterprise. They’re very excited by it. I think one of the reasons why they’re so excited by it and they’re so allured to it is that there is this sense that “Oh, I can have my cake and eat it too. I can make money and feel good about it.” One of the things that I want to say to them constantly is like, that’s not entirely true. There are trade offs.
In social enterprise, there have to be trade offs because—and to use the analogy of microfinance again, when you’re providing microfinance services, you’re not creating, you’re not producing anything. You’re giving money to poor people and you’re charging an interest rate for it. Every additional dollar of profits you make is a dollar that you’re not investing in these poor people or it’s a dollar that you’re taking away from them and you have to be very aware about this, right.
Now, of course, you don’t want to waste that dollar. You don’t want to have a wasteful organization, but focusing only on profitability and assuming that there’s no trade off, it’s just a false assumption because that means whatever dollar in profits you’re not making, you’re taking away from somewhere else and you have to be very aware of that. And that’s true for any kind of social enterprise. If you’re thinking about sort of environmental social enterprises, any additional dollar in profits that you’re squeezing out of your model is a dollar that is not going somewhere else.
Because it turns out that the reason why we need social enterprise in general is because the market hasn’t fixed it. The reason why there’s a problem there that requires an NGO and now, a social enterprise is because there’s something that is non-economic about this problem. If it was economic, the market would have solved it a long time ago. So we need hybrid models or social enterprise models that can kind of bring the market into this problem in a way that bridges it. But let’s be clear that the market hasn’t fixed this and there’s no way the market can fix it in and of itself. So there’s a trade off there. The fact that the problem still exists tells you that there’s a trade off there and that if you want to go and fix that problem and assume that you can make as much money as firms that are operating in non-social enterprise models or regular enterprises, there’s a weird assumption that you’re making there.